When people talk about asset allocation, they usually refer to the relative amount of stocks or bonds in their portfolio (like the model portfolios shown here). But I am occasionally asked whether to include personal home equity in asset allocation. If you have a significant amount of home equity, does this mean you are overexposed to the Real Estate sector? Should you change your other investments to compensate?
Conspiracy Theory Argument
Professional portfolio managers are usually paid based on a percentage of assets under management, or when you make trades. Since they don’t usually control your home equity, they can’t charge you for it, which is why some say the industry secretly decided it shouldn’t be included in asset allocations.
I’m not so sure about this one. Most people don’t have professional money managers. And if they do, for example I’m betting that most advisors would include a huge 401(k) in their planning even they didn’t control it.
Pricing and Liquidity Argument
It is very hard to determine the true market value of an individual house. You can’t sell only a portion of it, which means you can’t rebalance relative to other asset classes. Because of these issues, some people say personal home equity shouldn’t be included.
Still, this is also true of investment/rental properties, which I think should be included in asset allocations just as much as owning any company with physical assets.
My Answer: It Depends?
I plan on staying in the same geographical area indefinitely. Once I’ve committed to buying a place, I’m mainly trying to pay off all “future rent” at once. If I never move, then obviously it won’t much to me what happens to housing prices. If housing prices in my area go up, then my house value will go up, and an alternative house I want to buy will go up. The opposite will be true if housing prices go down. Over the long term, prices should pretty much match inflation. So I don’t consider my house as part of my portfolio.
However, if I planned to sell my house upon retirement, and then use the money to move to a significantly cheaper home and use the difference to cover other expenses, then I would care about my house value because I would have to “cash out” at some point. Some people end up relying on a reverse mortgage to pay for things, which would be a similar scenario.